ACCOUNTING- AND

FINANCE-BASED MEASURES
OF RISK
 Introduction
• An important objective of the analysis of
financial statements in general and that of
ratios in particular is an assessment of the
risk inherent in a firm’s operations
– Credit risk
– Equity risk
• One indicators used to forecast financial
risk measures is firm’s earnings variability
 Earnings Variability and Its
Components
• The variance of a firm’s earnings is a
direct measure of the uncertainty (risk) of
its earnings stream
• A smooth earnings stream is assumed to
be desirable by firms, their creditors, and
the financial markets
• To the extent that accounting earnings
mirror a firm’s economic well-being, the
variance in that measure would be
expected to measure a firm’s risk
 Earnings Variability and Its
Components
• Earnings volatility is primarily related o the
underlying uncertainty of demand for the
firm’s output  the variability of its sales
• The effect of sales variability on earnings
variability is a function of the firm’s
operating and financial leverage
• Earnings variability has a systematic as
well as unsystematic component  the
systematic component is referred to as the
accounting beta (B)
 Components
• Operating and Financial Risk
– Operating leverage is the percentage of fixed
operating costs in a firm’s overall cost
structure
– Financial leverage is the percentage of fixed
financing costs in a firm’s overall cost
structure
• The higher the percentage of fixed costs, the
greater the variation in income as a result of
variation in sales
 Components
• Measures of Financial and Operating
Leverage
– Financial leverage: use surrogates (times
interest earned, debt/equity, debt/assets)
– Operating leverage:
• Using regression analysis:
TC = F + vS
TC = total cost, S = Sales, F and v = estimates of
firm’s fixed costs and variable costs
• Ratio of fixed assets to total assets
 Components
• Accounting Beta
– Systematic factor reflects the degree to which
the earnings of the firm vary with the earnings
of other firms in the economy (accounting
beta):
E = a + BearningsME
E = firm’s earnings, ME = index of market
earnings, Bearnings = accounting beta
 Credit Risk
• The focus of credit risk is the risk of
default, resulting in loss of principal and
interest.
• The ultimate form of default is bankruptcy
 Credit Risk
• Bankruptcy prediction
– The ability to predict which firms will face
insolvency in the near term is important to
both potential creditors and investors
– Considerable research into the use of ratios
and cash flow data to predict bankruptcy
 Credit Risk
• Bankruptcy prediction
– 2 types of misclassification errors:
• Type 1 error: misclassification of a firm by
predicting nonbankruptcy when in reality the firm
becomes bankrupt
• Type 2 error: misclassification of a solvent firm as
bankrupt
• Type 1 error is more costly than Type 2 error
 Credit Risk
• Research results
– Univariate Models
• Beaver (1966): cash flow/total liabilities proved to
be the best predictor overall
– Multivariate Models
• Altman: Altman’s (1968) Z-score model and ZETA
model [Altman et al. (1977)]
• Ohlson (1980)
• Gentry et al. (1985b): a model that combined cash
flow variables with financial ratios performed better
than one based on cash flows or financial ratios
alone
 Credit Risk
• The Prediction of Bonds Ratings
– The ratings attest to the creditworthiness of
the firm
– The higher the ratings, the lower the
probability of default
– To compensate for higher default risk, lower-
rated bonds are issued with higher yield
 Credit Risk
• Impact of ratings:
– The higher the rating, the lower the interest
rate required
– The covenants written into bond offering are
often designed to obtain favorable ratings.
Some covenants are specifically tied to
ratings, and may require a higher interest rate
or redemption if the rating fall below a
specified level
– Many institutional investors are restricted to
debt with minimum debt rating
 Credit Risk
• Usefulness of Bond Ratings Prediction
– Most firms have unrated debt
– Ratings are not continuously revised, and there is
evidence of considerable lag
– Firms sometimes undertake large investment or
acquisition program
– Independent variables in a predictive model can
provide insight into the important factors that
determined the (perceived) riskiness of debt
– Ratings at the lower end of the spectrum may be
inconsistent and rigid
 Equity Risk: Measurement and
Prediction
• Risk and Return
– Risk:
• Unsystematic risk: factors specific to the firm
– Diversification eliminates unsystematic risk
• Systematic risk: factors common across a wide
spectrum of firms
– The only risk measure that remains relevant
– E(Rt) = a + βeE(Rm)  β is a measure of systematic risk
 Equity Risk: Measurement and
Prediction
• Importance and Usefulness of Beta
– To construct investment portfolios with the
desired risk and return characteristics, you
must know the beta of individual
characteristics
– Discounted CF valuation models require an
estimate of the firm’s expected rate of return.
Beta can be used to estimate that return
– Management in making capital budgeting
decisions needs to know the firm’s cost of
capital.
 Equity Risk: Measurement and
Prediction
• Empirical Studies
– Ball & Brown (1968) found a high degree of
association between the accounting beta and
market beta
– Lev (1973) the lower the variable cost, the
higher the total variance of returns and the
higher the beta
– Beaver et al (1970)  dividend payout,
financial leverage, earnings variability, and
accounting beta have significant correlations
with βe
 Equity Risk: Measurement and
Prediction
• Fama & French (1992):
– Problems for the CAPM (and β):
• Alternative measures of “risk” tend to be (more)
closely related to returns
• Returns are not related to β